But reading a paragraph from Seth Klarman’s Margin of Safety changed my view where he talks about why you shouldn’t use dividends in valuing a business:

The dividend-discount method of valuation, which calculates the present value of a projected stream of future dividend payments, is not a useful tool for valuing equities; for most stocks, dividends constitute only a small fraction of total corporate cash flow and must be projected at least several decades into the future to give a meaningful approximation of business value. Accurately predicting that far ahead is an impossibility.

But what made me think I can disregard market timing if a stock’s div. yield + growth rate is bigger than discount rate? The sentence “dividends constitute only a small fraction of total corporate cash flow”.

What this implies is a dividend-discount method of valuation is a very conservative method of valuation. If the dividends in itself provides the necessary returns to beat my discount rate, then you should go for it since it holds a large margin of safety.

But what about Seth Klarman’s complaint that “Accurately predicting (corporate cash flow projections) that far ahead is an impossibility”? This can be solved through a conservative discount rate, a conservative growth rate, a conservative payout ratio, a long dividend growth history (min. 10 years) and a wide moat.

What is deemed a conservative discount rate? Choosing the 30 Year Treasury Yield as my risk-free rate benchmark, I select the higher of either the current yield, historical mean or historical median. Then I multiply it by how many dividend aristocrats cut/eliminated dividends in 2008-2009 [1] before further multiplying it by 1.5 [2].

What is deemed a conservative growth rate? I first choose the lower of either the 1 year, 3 year, 5 year or 10 year dividend growth rate. I then discount it based on dividend growth history (if 25 or above years, discount by 1/3, if 10-24 years, discount by 2/3, if less than 10 years, treat as zero growth).

What is deemed a conservative payout ratio? I demand that the 5 year average payout ratio is below 2/3.

The rationale behind favoring stocks with long dividend growth histories is that a very long dividend growth history filters out companies that could consistently grow dividends by luck rather than possessing a wide moat, and that it is very likely that the company’s growth is predictable as a result.

Both of these considerations together combined with an extremely conservative valuation allows me to relatively accurately predict corporate cash flow projections several decades into the future.

And as a last line of margin of safety, I demand that I have at least 16 stocks for diversification purposes, which means I will only buy up to 6.25% weighting for each stock. If any of the aforementioned stocks die, my portfolio doesn’t have to die with it due to diversification, wide moat and conservative valuation.

After all, if a wide moat stock with long dividend growth history has its dividend yield and conservative growth rate beat your conservative discount rate, you have a huge margin of safety, thus rendering market timing useless.

[Notes]

[1] The reason why I use 2008-2009 is because I only have the statistics from that period of how many dividend aristocrats stopped being dividend aristocrats during stock market crashes. Also considering 2008-2009 was one of the most serious stock market crashes in history, it would be a good benchmark on the ability of dividend aristocrats to have its status remain intact during a black swan event.

[2] 1.5x basically implies I buy a dollar for 67 cents. The margin of safety provides safety for factors I overlooked, and also ensures I buy at an at least decent undervalued price rather than just fair value.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)